Commentary: Sharp realignment is the best chance

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Yesterday's events had all the appalling drama of a gladiatorial contest between an immovable will and an irresistible force. The Government appears to have sanctioned the most massive support-buying of sterling in our economic history: as much as dollars 20bn worth of foreign currency has been spent out of a total of perhaps dollars 44bn. At that rate of depletion, it must have been clear to the Treasury that intervention could not hold the exchange rate.

The markets had scented blood. They had pushed the Italian lira out of the exchange rate mechanism and were evidently determined to do it again. Sterling was next in the firing line: a currency where high interest rates were already inappropriate, where the Government was clearly reluctant to raise them, and where devaluation was a traditional if now disavowed remedy for economic ills.

The essential problem, once the markets had thought themselves into this frame of mind, was that the only thing that could decisively turn events around was a sign of serious commitment to existing parities from the authorities of the currency that is going up, rather than those of the currency going down. In other words, the Bundesbank needed to shave more off its interest rates than Monday's quarter percentage point. But the German central bank has not been feeling charitable towards its ERM charge.

Apart from intervention, the only other shot the Government had was an interest rate rise. But even 5 percentage points (three of them now reversed) failed to hold the rate. Overnight interest rates soared to 100 per cent. But these interest rates are all annualised: they are what people would earn on sterling if the rates stayed at that level for a year, which they will not.

Remember that the interest rate needed to compensate investors for holding a currency that they believe will devalue tomorrow by, say, 10 per cent is 10 per cent per day not 15 per cent per year.

It is hard, therefore, to cavil with the Government's decision to let the parity go. In reality, it had little option given the strength of the market forces ranged against it. Why, though, not opt for a clear devaluation of the central rate within the ERM as the Italians did at the weekend? The real argument is that the markets remain febrile ahead of the French referendum. There was no way of seriously judging what a new target rate should be, and almost any exchange rate would be immediately tested by the foreign exchanges. The intention is now to let the pound find its own level in trading after the French referendum result, and then to refix it within the system.

The Government would be wise to refix sterling before too long: the half-way house of a Swedish solution provides no guarantees against monetary buffeting. But equally, the pound should re-enter the system at a level clearly below most of the market estimates of the fundamental rate. We would be able to reduce interest rates substantially, perhaps even below German levels, if it were supposed that the pound could rise in its new ERM bands.

The consequences will be mixed. Inflation will certainly be higher than it would otherwise be: perhaps by as much as 2 or 3 percentage points a year over the next few years, despite John Muellbauer's optimism below. Wage claims would probably tick back to the 5 to 10 per cent range before long. Although the bond market might take heart from any decline in short-term interest rates, it would soon worry about the longer-term outlook for higher inflation.

Nor will this price in terms of higher inflation buy a rapid solution to the problems of the real economy of output and unemployment. Those who have repeatedly chanted the mantra that our problems are due to the exchange rate mechanism will be in for a surprise. The experience of the United States, where interest rates have fallen to just over 3 per cent with little demonstrable effect in spurring the recovery, surely shows that high debt levels exert substantial deflationary force in their own right. Lower interest rates might speed up the period during which debt levels are worked off, but they will not in themselves spark a convincing recovery in domestic demand.

The fundamentals of the UK economy will thus remain unchanged: we will continue to run a trade deficit that needs to be rectified by a prolonged period of slow domestic demand and strong export performance. Our inflation will be higher, and we may even suffer periodic devaluations against the German mark. Old reputations die hard.